Uncle Sam on the hunt for tax revenue

By Charles Davis
August 30, 2011

On the hunt for more tax
revenue, the Obama administration is turning its attention to
potential new sources lurking in the life industry, including
corporate-owned life insurance and life settlements. However, the
administration faces stiff opposition from the Republican Party,
reports Charles Davis.

As budget woes worsen in the
US, the federal government is on the hunt for new sources of
revenue. While Republicans vow to block any new tax increases, the
administration has made it clear that it will attempt to increase
tax rates on three of the life industry’s most profitable and
highest-volume products, corporate-owned life insurance (COLI) and
variable life and variable annuities.

The life insurance industry
warns of dire consequences to the tax planning of small businesses
and families and is opposed to the plan as well. The industry’s
political odds could improve as Congress and the administration are
under pressure to close tax loopholes as a means of addressing
runaway budget deficits. There is no way to reach any meaningful
deficit reduction without addressing both cuts and increased
revenue.

In April 2011, 31 of the 37
members of the tax-writing House Ways and Means Committee wrote a
letter to the Obama administration asking it to abandon efforts to
impose new taxation on COLI as well as limiting life insurers’
dividends received deduction on variable life and variable annuity
products.

The administration replied,
defending its taxation goals by saying it was merely trying to end
the “tax arbitrage” that results when interest expense allocable to
tax-preferred inside build-up on life insurance contracts is
deductible. Specifically, this refers to the practice of profiting
from differences between the way transactions are treated for tax
purposes. For instance, in the case of variable annuities, it means
allowing interest expense to build up inside a variable annuity and
then also making the contract tax deductible.

The White House proposal
addresses issues left unmentioned by the COLI best practices
provision of the 2006 Pension Protection Act.That provision
addressed consumer protection issues and abuses in use of COLI by
businesses that had been addressed by several courts in the late
1990s and in early 2000s.

In announcing the proposals
in the administration’s proposed budget for 2012 in February,
Treasury Secretary Timothy Geithner justified the new taxes by
saying: “We are taking the next step in creating fairness in our
economy by ending loopholes that allow companies to avoid paying
taxes whilems of hardworking families and small businesses pay
their fair share.”

The same provisions were
included in administration budgets for fiscal years 2010 and 2011,
but each year Congress gave them a cold reception, Geithner
said.

New tax on
business

The COLI shift would
effectively be a new tax on business, according to a joint
statement from industry bodies, including the American Council of
Life Insurers, the Association for Advanced Life Underwriting and
the National Association of Insurance and Financial
Advisors.

In the joint statement the
organisations stated: “The COLI proposal would impose new taxes on
life insurance used by businesses small and large. Many businesses
use COLI to protect against financial or job loss stemming from the
death of owners or key employees. COLI is also used to ensure
business continuation. In addition, COLI is a widely used funding
mechanism for employee and retiree benefits. Congress affirmed the
benefits and tax treatment of COLI and ensured its responsible use
in bipartisan legislation enacted in 2006.”

The administration’s spending
plan would also reduce the dividend received deduction life
insurers utilise in accounts that fund variable life insurance and
variable annuity contracts. The deduction is estimated to be worth
$2.4bn over the next five years.

“With our economy still
recovering from the recent crisis, public policy should encourage
families and businesses to responsibly plan for their financial
futures. The administration’s budget proposal would have the
opposite effect,” according to the statement.

The COLI proposal would deter
companies from deducting the interest expense on the cash value of
life insurance policies they have taken out on executives,
effectively taxing the inside buildup of newly sold policies. The
move would reduce the federal deficit by an estimated $7.7bn
between 2012 and 2021.

The proposed change to the
calculation of dividends-received deductions was floated last year
and has been brought back for a second chance as well. The
administration’s measure would reduce the deduction that a life
insurer received based on the proportion of its policyholder
reserves to its separate-account assets.

Life settlements
targeted

Another proposal would step
up tax reporting on life settlements, ensuring the payment of tax
on the death benefits, as well as reporting in connection with the
sale of the policy to ensure that the seller paid taxes on the
proceeds. Specifically, under the regulation planned for
introduction in 2012 anyone who purchases an interest in an
existing life insurance contract with a death benefit of $500,000
or more would have to report the purchase price, the buyer’s and
seller’s taxpayer identification numbers (TIN) and the issuer and
policy number to the Internal Revenue Service (IRS) to the
insurance company that issued the contract to the seller. Upon
payment of any policy benefits to the buyer, the insurance company
would be required to report the benefit payment and the buyer’s TIN
to the IRS.

Finally, another provision
would hit banks and thrift holding companies with an accountability
fee in order to recoup cash used for the Troubled Asset Relief
Program.

Even in their present form,
if all were enacted, a team of analysts from stock broking firm
Keefe Bruyette Woods Inc came to the conclusion that they may still
have only a small effect on company profits.

“Although general account DRD
[dividend received deduction] is discussed, our initial reading is
that the proposal, like last year, would primarily affect separate
account DRD,” the analysts wrote. “As a result, it appears the
impact would fall primarily on companies with material separate
account business.”

Odds are long, however, that any of the provisions will
remain intact, given the fractious politics in Washington these
days. The Republican Party remains completely opposed to any new
revenue at all, making compromise impossible – at least until the
political will runs headlong into electoral politics.